Wednesday, October 31, 2012

The Goldman Sachs Analyst Index (GSAI) hit a new post-recession low this month. The index is a composite of corporate outlook by industry from Goldman's company research. In the past, the index generally fell in line with other economic activity indices such as ISM Manufacturing - but not recently. While the ISM index is showing a slight expansion (though we don't yet have the October ISM number), GSAI is pointing to the sharpest contraction across US industries since 2009. Sales, shipments, new orders - all came in weak. This indicates that the positive economic numbers in September (see discussion) may have been an aberration.

GS: - The Goldman Sachs Analyst Index (GSAI) tumbled to 32.9 in October from 44.1 in September. Underlying components also fell across the board, suggesting depressed business activity from the bottom-up.
...
In addition to the headline index, most of the underlying components of the GSAI also fell sharply. The sales index gave back its gain in September, falling 12 points to 36.4 in October from 48.4, registering the fifth consecutive month below the 50 mark. Similarly, the new orders index fell 15.4 points to 26.3 from 41.7, contributing 4.6 points alone to the headline drop. The inventories index saw the lone gain, rising 1.6 points to 43.3. Consequently, the orders-inventories gap fell back into negative territory at -17.0 versus flat in September. The sharp reversal in the sales, new orders, and orders-inventories gap measures suggest that the broad improvement in September was likely transient, and that activity and demand will likely remain depressed despite tight inventories.

Source: GS

This points to significant downside risk to the ISM Manufacturing number that comes out tomorrow (Thursday). Another troubling indicator from GS is the GSAI Employment Index - a component of the overall GSAI measure.

Source: GS

GS: - The employment index fell for the second consecutive month to 39.3 from 45.3 in September. This is the lowest index level since February 2010, and—similar to weakness in the employment component in the Empire State and Philadelphia Fed surveys—continues to point to a slow recovery in the labor market. While the September employment report showed encouraging improvements particularly from the household side, the pace of improvement is unlikely to sustain; we expect only a moderate gain of 125,000 in nonfarm payrolls in the October employment report on Friday.

Based on the GSAI indicators, we could be looking at a series of negative economic surprises as October economic numbers are released next month. Economic activity and corporate earnings in Q4 may in fact end up being far less rosy than many expect.

With investor demand for leveraged loans remaining strong (see discussion), one structural component has not changed. The majority of new leveraged loans still have a LIBOR floor. That means these loans will pay a minimum coupon plus spread, no matter what LIBOR does. In fact according to LCD, the average floor of 1.25% in October has changed little this year for new-issue loans in spite of investor demand for the product. That is investors want these loans but they will typically only buy loans that have the LIBOR floor included. A loan with a spread of 3% and a floor of 1.25% will pay 4.25% (act/360) annually, even though the 3m LIBOR is only 0.32%. The chart below shows the percentage of new issue loans with a LIBOR floor and the average floor level for each month.

Source: LCD

Those who think in terms of options will recognize that the borrower (in addition to paying the usual LIBOR + spread) has written the investor/lender a series of in-the-money put options on LIBOR (an in-the-money LIBOR floor). Even the options with longer maturities are in-the-money because the forward LIBOR curve is below the average floor level all the way out to 2016 (option strike level is above the forward underlying). And most of these loans do not go too far beyond that point. Even if the maturity is out to five years, most loans will amortize/prepay to a shorter average maturity (at least based on history).

Source: LCD

The rationale for maintaining a LIBOR floor on new deals is simple. Given the Fed's efforts to maintain near zero rates for a prolonged period of time, the probability of LIBOR rising substantially is low. In order for this product to compete with high yield bonds, which are fixed rate instruments, it needs to guarantee some minimum coupon in spite of what the Fed is doing. To be sure, investors holding these loans will receive a smaller coupon on average than with high yield bonds, but the floor makes that difference less of an issue.

What attracts some investors to leveraged loans is that they receive a minimum coupon because of the floor but to some extent they also get an inflation hedge. Should inflation surprise to the upside, LIBOR may in fact rise above the floor level, increasing the coupon. HY bonds on the other hand will continue paying a fixed coupon.

Another recent survey seems to indicate that the Eurozone institutional investors are taking on more periphery risk. With the ECB backstop in place (see discussion), investors in the area have shifted to being long periphery debt vs. the core. Given this increased appetite for risk, should the expected ECB aid to Spain fail to materialize (see discussion), the selloff could be quite violent.

JPMorgan: - Investors have shifted their peripheral positioning to long
in recent weeks which could become a risk for intra-EMU spread
tightener trades.

The Japan-China tensions are taking their toll on the Japanese economy. The latest industrial production numbers, which include the period of escalating rift between the two nations, look quite dismal.

Source: tradingeconomics.com

In fact both production and shipments are down significantly - the worst decline since the March 2011 tsunami disaster.

Source: Ministry of Economy, Trade and Industry

In response, BOJ launched another round of QE - as was widely expected. As usual a central bank is asked to solve problems that should be left to the governments (similar to the Fed with the fiscal cliff and the ECB with the sovereign debt crisis).

WSJ: - The central bank's policy board decided Tuesday to increase the BOJ's asset purchases to ¥91 trillion ($1.14 trillion) from ¥80 trillion, and to introduce a new lending facility designed to stimulate loans by banks. The fresh measures marked the first time since May 2003 that the BOJ has taken easing steps two months in a row. The bank said it took action to keep Japan's economic policy on the path "to sustainable growth with price stability."

The BOJ also downgraded its assessment of the economy, noting declines in both exports and output, key drivers of the country's economic growth. "Japan's economy has been weakening somewhat," it said in a statement, compared with its previous description of economic activity as "leveling off more or less."

In the mean time the conflict between the two nations continues to brew - particularly with respect to the disputed islands (see discussion).

CBS: - Chinese patrol boats confronted Japanese vessels near a disputed East China Sea archipelago early Tuesday, the latest in a series of such encounters following Tokyo's nationalization of the islands last month.

Four ships from China Marine Surveillance entered waters near the islands at 10 a.m. (0200 GMT), according to a statement from the State Oceanic Administration that commands the service. The ships conducted surveillance on the on Japanese Coast Guard vessels in the area, "sternly expressed" China's sovereignty claim over the islands and "carried out expulsion measures," the administration said.

Some now believe the real reason behind the conflict has to do with oil and gas reserves under the East China Sea. A worrying new development in the conflict however was an influential former Chinese diplomat accusing the US of instigating these tensions between China and Japan.

NYT: - A longtime Chinese diplomat warned Tuesday that the United States is using Japan as a strategic tool in its effort to mount a comeback in Asia, a policy that he said is serving to heighten tensions between China and Japan.

... the thrust of his speech was more hard-hitting, particularly regarding the United States. Some in China and Japan see the issue of the islands “as a time bomb planted by the U.S. between China and Japan,” he said. “That time bomb is now exploding or about to explode.”

Mr. Chen accused the United States of encouraging the right wing in Japan, and fanning a rise of militarism.

“The U.S. is urging Japan to play a greater role in the region in security terms, not just in economic terms,” he said during his speech at the Foreign Correspondents’ Club in Hong Kong. That “suits the purpose of the right wing in Japan more than perfectly — their long-held dream is now possible to be realized.”

This accusation that the US is behind the rift between the two nations was echoed by a Chinese newspaper on Monday. China apparently was rankled by the recent US-Japan-India meeting that excluded Beijing.

The Hindu: - Chinese state media outlets and strategic analysts have expressed wariness at the India, Japan and the U.S. trilateral meet held in New Delhi on Monday describing it as aimed at exerting pressure on China over its regional ambitions.

[The Communist Party-run Global Times] newspaper said the U.S. was “trying to ensnare China in the Asia-Pacific region”, even as the business community in Washington was becoming increasingly “integrated” with China. “The U.S. often holds an ambiguous strategy on China. It seems Washington hasn’t made it clear how it should deal with China’s rise.”

With Japan now economically "stressed" and China trying to assert its dominance in Asia-Pacific, these developments could destabilize the region. The alleged involvement of the US in the conflict has the potential of making the situation even more dangerous. And none of this is good news for economic growth in the region.

Tuesday, October 30, 2012

Silvio Berlusconi has been a supporter of Monti's government until recently. But there is a possibility the former Prime Minister may decide to re-enter politics once again. This is particularly troubling, not only due to the risk of Berlusconi rolling back Monti's austerity measures but also because the man is a crook - there simply isn't another way to put it. On Friday he was convicted of tax fraud by a court in Milan. OK, that happens to a politician or two. But this is not the first time for Mr. Berlusconi.

WSJ: - This is Mr. Berlusconi's fifth conviction since 1990, though so far he's managed to avoid his sentences for alleged perjury, corruption and false accounting, thanks to amnesty laws, successful appeals and expired statutes of limitations. Friday's sentence has already been reduced to one year, and despite the verdict, he won't set a foot in jail until his lawyers exhaust Italy's appeal process, which could take years. Even if the expected appeal fails, the proceedings may well let Mr. Berlusconi run out the statute of limitations on tax fraud.

He has also been pulled into another trial that involves his relationship with an underage woman - which of course he denies. What's amazing however is that in spite of all this, Mr. Berlusconi could in fact garner enough political support to run in the next election. And he can do it by tapping into the public's disillusion with current conditions in Italy. The prolonged recession (see discussion), austerity measures, higher taxes (and more enforcement of tax evasion laws), high fuel prices, nearly 11% unemployment rate, etc. makes for some unhappy voters. This unease among the Italian population is evidenced by the latest consumer data. Consumer confidence has declined sharply since last year.

Source: tradingeconomics.com

And with it went consumer spending and retail PMI (released today). Consumer expenditure has been worse than the lows of 2008-09.

Source: Markit

This increases the risk of potential troubles for Mario Monti's government and his supporters, particularly as Berlusconi - after his conviction last week - threatened to pull support for Monti's government. Berlusconi is in effect blaming Monti for somehow not allowing him to cheat on his taxes.

Chicago Tribune: - The election for a regional government in Sicily is a major test ahead of a national poll in April but the picture has been confused by Berlusconi's threat at the weekend to pull support from Prime Minister Mario Monti and bring down his government before an election expected in April.
...
Berlusconi's angry attack on Monti's technocrat government, which his center-right People of Freedom (PDL) group has supported in parliament for almost a year, underscored the political confusion ahead of next year's national vote.

The billionaire former prime minister, convicted of tax fraud last week, attacked Monti's austerity policies on Saturday, announcing that the PDL may withdraw its support and bring the government down.

Mr. Berlusconi has been also known to make jabs at Monti before this attack, insinuating that the Prime Minister is a puppet of Germany or is controlled by bankers. This rift has split the main center-right party People of Freedom (PDL) into Berlusconi's and Monti's supporters. With Monti not expected to run in the next election, Berlusconi could potentially make a move. Whatever the case, next year's elections in Italy will be critical, as Monti's efforts to put the government on a fiscally sustainable path (that finally gave Italy some credibility) could easily be reversed, threatening the recent signs of stability in the Eruzone.

Spanish Prime Minister Rajoy has continued to indicate that he will formally request more assistance when it is in the country's interest, which essentially means, when he is good and ready. And he is not now.

Following his meeting with Italy's Monti, Rajoy was quite candid. "The most important thing", Bloomberg quotes him saying, " is that the mechanism is there. He is acknowledging the actual value of the Outright Market Transactions (OMT) lies in its presence not operation.

Yet there is only so long that the market affections can be toyed with. The poor performance of Spanish bonds last week and the continued selling pressure today suggests investors patience is running thin. Draghi and the ECB had given Spain a reprieve in the form of the LTROs and the OMT.

Spanish bank deposits rose in September and anecdotal reports suggest a modest increase in foreign participation in the government auctions. Fitch's survey of the top ten US money market funds also found new exposure to European banks.

Rajoy is obviously and understandably reluctant to ask for broader assistance. And why should it? It still has access to the capital markets. That identifies the first condition that would likely force Rajoy's hand, namely, a dramatic rise in interest rates.

This is a distinct possibility, especially if one view the recent capital inflows as one-off adjustments, perhaps in part driven by benchmark/index considerations, as opposed to a reflection of new found confidence/optimism.
The risk-reward has also shifted. Spain's 10-year generic bond yield has ranged between about 5.0% and 7.75%. The Draghi-induced rally saw the yield more than 200 bp to the lower end of the range (~5.25%).
In addition, given the government's rosy forecast for only a 0.5% contraction next year, any signs of weaker growth trajectories could perversely weigh on bonds on account of the implication for the budget deficit. Typically, one expects weak or disappointing economic data to push yields lower, but in Spain, the dynamics may be overwhelmed by the fiscal impulses. Deeper economic contraction means large budget deficit and more debt.

The second condition that could force Rajoy's hand if he could not longer protect Spain's pensions. This is important in a country of 10 mln retired people in a country of 47 mln people.

It is the single biggest line item of the budget, accounting for 40% of spending and 9% of GDP (France 15% and Italy 13% for comparison). Given it size, it is clear that serious fiscal reform cannot take place without a discussion of pension. So far Rajoy has protected pensions in a way that Greece did not. In fact, the 2013 budget will fund a 1% increase in pensions by drawing down the fund's reserves.

Some reports suggest Spain's pensions also are part of the inter-generational transfer taking place. The government estimates that 1.7 mln of the 16 mln Spanish households have no salary income. Pensions in Spain appear to help support children and/or grandchildren.

Spain and Italy are on the same side of numerous debates in the euro area. They are both significant debtors and in the current environment this counts for a great deal. This is fine for the milquetoast joint press conferences, but below there surface there is a prisoners' dilemma game being played out and Monti is not cooperating.

It would be best for both if neither needed financial assistance.

Second best would be to ask jointly. Some Italian and French officials seem to think that if Spain were to formally request aid that it would help stabilize the financial markets. Monti may think Italy is being dragged down by Spain. However, the risk is that they are wrong: that if Spain gets assistance, the market, even if not immediately, will re-focus on Italy. What they do not seem to appreciate is the first mover advantage. A firewall is drawn and Spain in on one side and Italy on the other.

However, if Italy and Spain sought a precautionary facility simultaneously, it would reduce the stigma and be a stronger firewall. In fact, there might be nothing like a simultaneous French request in sympathy to solidify the firewall. France would not have to drawn on the line, of course. Precautionary lines of credit for Spain and Italy and France would do for sovereigns what the largely unused bilateral currency swap lines do for financial markets--ensured their ongoing operations.

The third permutation that might move Rajoy off the stick and on the ball is his friends in Europe would seek precautionary facilities at the same time. No one is talking about a package for Italy, but at the press conference after meeting with Rajoy, Monti again made a point of essentially saying that Italy was not Spain. It did not need assistance.

Given that Monti heads up an un-elected technocrat government, it would not appear he has a mandate to enter into a multi-year commitment with the Troika. However, a move in conjunction with Spain (and France), could be presented by multilateral initiative. An agreement with the Troika could help increase the odds that the successor government (next spring) does not unwind Monti's reforms.

It would allow Hollande to head up a faction to do what France an no longer do on its own and that is serve as a counter-weight to Germany. It would bring into better balance the interests of the creditors and debtors and sustaining that tension, without an all out victory for either side, is what it is all about.

Nor will the countries really be giving up anything that won't be taken away shortly. Schaeuble's proposal, endorsed by Draghi, for stronger and more invasive EU (Monetary Affairs Commissioner) oversight of national budgets, would further weaken fiscal sovereignty.

It is not clear what European officials mean when they say they will do anything it takes to save the euro. Does it mean asking for a precautionary facility? It is precautionary rather than reactive. The current strategy remains reactive. The Rajoy and Monti meeting was an opportunity to break this dynamic. If Monti (and Hollande) want Rajoy to take a package, there may be no better way to persuade him than by taking a package themselves.

The alternative, is succumbing to increased pressure, either directly through the markets, where the country faces record debt refinancing next year, or indirectly through the deterioration of the social fabric.

It is because Europe moves by crisis that the euro is may have to work its way lower still. Key support has been established near $1.2800 and there has been talk of official interest below $1.2900. Many suspect that the euro is in a lose-lose situation. The economic and financial fall out from US not being able to avoid the full force of the fiscal cliff is thought to make investors more risk averse, which is thought to help the dollar. Alternatively, the fiscal cliff is avoided or mitigate and a US recession is avoided, and the superior returns and unresolved European debt crisis weighs on the euro.

But the fastest growth is expected in places one would not necessarily pick out intuitively. Some of the smallest economies don't need to generate a great deal of output to show a high percentage growth. Here are the top 20 countries by GDP growth in 2013 according to DB:

Here is what chasing yield looks like in the current environment. The horizontal axis indicates the size of each US fixed income market (in $trillion). The vertical axis shows the yield adjusted for historical losses due to defaults (more on that later). The Agency MBS adjustment takes out the prepayment option (OAS).

Monday, October 29, 2012

Consumer spending increase in the US was today's big economic story, with some viewing the increase as yet another sign of improving US economy.

LA Times: - Consumer spending rose 0.8% in September, the third straight monthly gain and the biggest increase since February, the Commerce Department said Monday.

Personal consumption expenditures increased $87.9 billion last month after increasing a revised $59.9 billion, or 0.5%, in August. Consumer spending has been up each month since coming in flat in June following a decrease of 0.2% the month before.

September's figure came in above analyst expectations of an increase of 0.6%.

"This means the fiscal cliff is not worrying consumers at this point like it is the business sector," said Chris Rupkey, chief financial economist for the Bank of Tokyo-Mitsubishi in New York, noting business investment spending was down in Friday's report on third-quarter economic growth.

Perhaps. But this one deserves a slightly deeper look. Here are some reasons it may be a bit early to celebrate a revival in US consumer spending.

The spending increase came at the expense of declining savings rate. Personal income grew by 0.4%, which means that the rest of the increase in spending had to come from declines in savings or expanding credit. We know that consumer credit remains flat except for growth in student loans (see discussion). That leaves savings, which indeed declined in September (chart below).

An argument could be made that in order to better understand this trend in spending, a more meaningful measure of consumer expenditures is the "chained" index (including taxes and inflation). In fact if one looks at the BEA page (here), that index is shown on the highlighted row below.

It becomes a simple exercise to see where the recent consumer spending trend comes from. If one plots a trend line through the Real Personal Consumption Expenditures (chained index) ignoring the bubble years, the growth is precisely where it should be if we continued the trend from the 90s. And this chained index shows that spending grew at a more moderate rate (0.4%) than the headline number - certainly nothing out of the ordinary.

Source: St. Louis Fed

Note that on chained basis, personal income growth in September was actually zero, meaning that the chained indices also imply that the consumer had to dip into savings. This indicates that even the trend in the chart above may not be sustainable unless real incomes grow or the consumer begins to borrow again. In particular with the lower savings rate, the consumer is now highly vulnerable to the shock of impending tax increases (or inflation).

Reuters: - While personal income last month grew 0.4 percent, the most since March and a step-up from August's 0.1 percent gain, the amount of money at the disposal of households after inflation and taxes was flat.

That meant households had to cut back on saving to fund purchases. The saving rate slipped to 3.3 percent last month, the lowest since November 2011, from 3.7 percent in August.

"We have only seen two lower readings on the savings rate in the recovery, which suggests that the consumer has virtually no cushion to absorb the scheduled tax hikes at the beginning of 2013," said John Ryding, chief economist at RDQ Economics in New York.

Bloomberg finally picked up the story discussed here a couple weeks back on the dying sovereign CDS market in the Eurozone.

Bloomberg: - European Union rules to curb
speculation on government debt are prompting an exodus from
credit-default swaps, making it harder for investors to insure
bonds and threatening to boost sovereign borrowing costs.

Trading has dried up on the Markit iTraxx SovX Western
Europe Index that was created in 2009 to help investors mitigate
government credit risk following the worst financial crisis
since the Great Depression. The volume of deals on the 14
nations now included in the measure fell 20 percent from last
year’s peak to $108 billion, the lowest since April 2010,
according to the Depository Trust & Clearing Corp [DTCC].

The European Commission, in its goal to decrease transparency into the health of European sovereigns, destroyed liquidity in this market. The extraordinarily naive view of the regulatory authorities of how this and other markets function is astounding and dangerous. Somehow they think that if one bank holds sovereign bonds, it will go to another bank and buy protection on those bonds. And if the bonds default the protection buyer will be compensated. That's silly. Both the buyer and the seller of protection will only enter into such agreement if there is an active two way market out there - they both need the ability to get out of this position at any time. The buyer for example may sell those bonds and will need the ability to sell the CDS as well. But the "naked short ban" killed one side of the market, taking out a big segment of protection buyers. The limited numbers of protection buyers simply took many participants out of the market altogether as liquidity risk made any participation dangerous.

Indeed this effect is visible in the DTCC data (for those interested, here is the link - it is by no means easy to find). The Markit iTraxx SovX Western Europe - Series 7 (the latest contract) volumes have collapsed. Below is the 4-week moving average volume of the volume over the life of the contract. In the first week of trading for SovXWE-7 about a billion worth of contracts traded. A week ago 40 million traded.

What's disturbing about this development is that without a liquid CDS market, lenders and investors may choose to stay away from certain countries or markets because they will have a limited ability to protect themselves. CDS is not insurance - most protection buyers don't wait for default to occur before monetizing their protection. When spreads widen, they need the ability to sell in order to take profits. The fact that the rules may allow them to buy protection is irrelevant when there is no liquid market out there. Congratulations EC - job well done.

Sunday, October 28, 2012

Hong Kong is taking extraordinary measures in an attempt to arrest what increasingly looks like a residential property bubble - much of it driven by foreign capital inflows (see discussion).

WSJ: - Hong Kong has levied a new 15% tax on property purchases made by foreigners, in one of the government's boldest moves yet to curb speculation in an overheating housing market.

Hong Kong Financial Secretary John Tsang said the new measures, which take effect Saturday, show the government's resolve to stabilize the residential market while the easy lending environment continues to boost demand for property despite an economic slowdown.

"This is an extraordinary measure introduced under exceptional circumstances," Mr. Tsang said in a news conference late Friday.

The announcement comes just days after the city's de facto central bank sold nearly $2 billion worth of the local currency to defend its peg to the dollar, a sign of hot-money inflows from the new round of U.S. credit easing that some analysts fear could affect real estate.
...
The city's government since 2009 has launched many measures to cool the market, such as raising transaction levies, boosting property available for housing development and tightening mortgage terms. But the efforts have done little to slow the rise in prices, as property investments have remained attractive.

In fact compared to other Asian property markets, including Singapore which usually mirrors Hong Kong markets, the city's residential property appreciation stands out.

JPMorgan: - Hong Kong, property prices tend to correlate well with Singapore; thus the firmness in Hong Kong property prices during 2H11 and through 1H12 runs at odds with the softening in Singapore.

Source: JPMorgan

There are a number of possible explanations for this development (and related developments such as the upward pressure on the HK dollar). Some believe this is a play on China and/or funds flowing out of Japan (as Japan's economic conditions dim - see discussion). It seems that asset allocators are rebalancing their Asia portfolios.

Whatever the case, the property bubble in Hong Kong looks quite real and the government action may in fact be a bit late.

MarketWatch: - Having left it so late to take aim at the influence of overseas buyers, there is now a much larger property bubble to deal with. The government has been warning about escalating property prices as far back as 2009, yet ignored repeated calls to limit overseas purchases.

Hopefully Barclays is not going to be too upset with this posting. This is one of the results of their latest survey of institutional clients on how the markets will react to the US presidential election outcome. It seems that participants were somewhat bearish on equities if Obama is reelected and bullish should Romney win. What's interesting is that sovereign wealth funds - basically foreigners - feel strongly that there will be a selloff if Obama is reelected. US banks on the other hand are on average neutral. But all agree that there will be a rally should Romney win the election. That's somewhat surprising given that Romney will be more proactive in cutting government programs - which is a negative for many blue chip stocks who view Uncle Sam as their key customer (see discussion). Maybe this is driven by expectations that Romney will ease on regulation or invest more in defense, helping some firms in the process. Thoughts? Comments?

California's Proposition 30 asks voters to decide on Gov. Jerry Brown's temporary tax increases. What makes this vote interesting at the national level is that it is California's version of the fiscal cliff. Clearly the proposed tax increases or the budget cuts will not have anywhere near the effect expected from the US fiscal cliff, but it works in a similar fashion. Either the state gets the needed revenue by taxing the "rich" or it will face automatic cuts. Of course those making $250K in LA are already heavily taxed and the new taxes may hurt business formation - but that's a discussion for another time.

LA Times: - Proposition 30, Gov. Jerry Brown's tax initiative, would narrow the state's budget gap by bringing in $34 billion or more over seven years — much of it by raising income taxes temporarily on those with incomes over $250,000, and the rest by a temporary, quarter-cent increase in the sales tax.

The income tax increase would expire after seven years. The sales tax increase would expire after four years. The initiative would also guarantee aid to local governments to help pay for the responsibilities that the Legislature shifted onto their shoulders through Brown's public safety realignment strategy.

If the initiative fails, $6 billion in automatic cuts would go into effect this year, mainly at the expense of public schools.

In fact education will absorb the bulk of the budget cuts, should the initiative fail.

JPMorgan: - Because Proposition 30 was crucial to the
Governor passing a “balanced budget”, mandatory
triggered cuts will go into effect should the measure
fail at the polls. ... most of the cuts would come from education, with a portion also coming
from Health and Human Services and childcare. Specifically, $5.5bn of cuts would come from Proposition 98 [ K-12 education] funding, and $250mn would come from both the University of California and the California State
University.

Source: JPMorgan

Apparently the public was generally supportive of Proposition 30 when it was first announced. After all taxing the "rich" to fund educational programs has been popular in the past. But now the questions have been raised on whether some of the state's education initiatives should be funded in such manner at all, particularly given Sacramento's history of wasteful spending. Maybe there are better ways to fund schools with additional taxes than through a centralized tax machine. Should the politicians prove that they are able to cut waste before they can be trusted with additional tax revenue?

An alternative to Proposition 30 is Proposition 38, which would raise taxes across the board (with the higher tax brackets increasing much more of course), but the funds would be walled off to be used for education only. 38 is not expected pass because while Californians support education funding, they don't want their taxes increased to pay for it (unless the increases are only on the top tax bracket).

Either way, the battle over Proposition 30 may serve as a litmus test at the national level for the public's willingness to trust the government with more tax revenue.

Equity funds are seeing outflows once again. Both mutual funds and ETFs are experiencing redemptions, as retail investors take profits. Funds that left equities seem to be flowing into investment grade bond funds, muni funds, and mortgage funds.

Saturday, October 27, 2012

What happens with all the corn that is not used for ethanol or animal feed? Many think it's used to make cereal and corn chips. But that turns out to be only 14% of all the non-ethanol corn usage. The biggest portion by far (36%) is used to make high-fructose corn syrup (HFCS). And much of HFCS is used for carbonated soft drink manufacturing. That means we should see soda prices in the supermarket continue to rise - which may be a good thing in terms of consumer health.

The UK GDP growth surprised to the up-side last week. And it wasn't just the Olympics-driven rebound.

JPMorgan: - A rebound in GDP in 3Q had been widely expected on the
grounds of several temporary factors. But the reported
1.0%q/q increase was twice the size of expectations. Excluding
bank holiday- and Olympics-related boosts in 3Q, GDP
appears to have shown an underlying expansion of close to
0.4%q/q in 3Q—with a broad-based pickup in services output
the main driver, and to a lesser extent a positive surprise on
manufacturing. Growth will slow in 4Q as energy prices rise
and temporary boosts fade. Moreover, the business surveys
have failed to indicate acceleration, raising the possibility that
the much weaker official data (up until 3Q) are playing catchup
with the PMIs. Nevertheless, there is a sense that a recovery
is taking place, with the GDP figures moving closer to the
strong labor market and retail reports seen over the summer
and into the autumn. Growth over 2Q/3Q has averaged
0.3%q/q versus the BoE’s August forecast of 0.15%.

Source: Tradingeconomics.com

It seems the UK is finally coming out of the nasty double-dip recession.

The Guardian: - So now we know what David Cameron meant when he said the good news would keep coming. The 1% expansion in GDP in the third quarter was the strongest since the world economy felt the first tremors of the financial crisis in 2007, and well above City expectations. Having been shockingly bad three months ago, the growth figures were surprisingly good this time – although not quite as good as they looked.

Two special factors flattered the data for the third quarter. The first was the bounce back from the output lost as a result of the extra bank holiday in June, which probably accounted for half the increase. The second was the Olympics, ticket sales from which boosted GDP by 0.2 points.

As a result, genuine growth in Q3 was probably in the region of 0.3%; not bad by Britain's recent poor standards but half the long-term pre-recession trend. Stripping out the distortions caused by one-off factors, the economy has probably been growing at an average rate of 0.2% in the last two quarters.

Clearly risks to the downside remain, particularly as the Eurozone continues to be plagued by weak economic activity - limiting Britain's growth. Credit in the UK is still tight, the unemployment rate is elevated, and household surveys show consumer unease (see discussion). But after three quarters of declining GDP, this is indeed good news for the nation that had struggled with economic malaise since 2008.

Many in the Western World mistakenly believe that the National People's Congress (NPC) ultimately makes key decisions in China (similar to a "parliament" in a typical democracy). That's only true on paper. The reality is that China's Communist Party (CPC) is firmly in charge, and People's Congress basically implements and passes down the decisions made at the CPC level. NPC "votes" as they are told. In fact CPC's Politburo Standing Committee is comprised of 9 men who make the key policy decisions and China's President answers to them only (even though on paper the president is supposed to be accountable to the NPC as well). China's Premier is simply an executive that administers the President's policy on a day to day basis.

That is why the upcoming leadership transition is so important: 7 of the 9 members of the Politburo Standing committee may be changing.

The ISI Group: - The CPC is the dominant political institution in China – in fact, it’s the only game in town. The
Politburo Standing Committee is the ‘head’ of the Party ‘body’ and is comprised of 9 members.
7 of the Standing Committee members will likely be replaced in 2012. New Standing Committee
members will be chosen by a combination of the current Standing Committee members, Party
elders, and CPC’s Central Committee.

All other upcoming changes in the government are basically superficial.

In spite of Friday's quick rally in yen, the sentiment has turned against the currency. As discussed before, the currency is now less likely to be used as a "safe haven". Some of course continue to argue that nothing has changed with respect to yen's status, but the data says otherwise.

WSJ: - Speculative investors have turned against the yen for the first time since late May, U.S. government data showed Friday.

Investors held a net short yen position--or positions that would benefit if the yen fell against the dollar--totaling $2.8 billion as of Oct. 23, according to the Commodity Futures Trading Commission's weekly report on the commitments of traders. It was the first time since May 29 that the majority of bets in the futures market favored a decline in the yen.

Goldman's JPY positioning index is flashing red as well - in spite of the increased uncertainty in the various risk asset classes (for example both copper and the yen declined this month).

Goldman: - The biggest mover in this week's COT report was JPY, where net positioning fell by -$4.4 bn from last week and now stands at -$2.8 bn ahead of next week's BoJ meeting and its biannual Outlook report publication. Speculative long positioning in the currency against USD fell by $2.8 bn, while traders increased their short positions by $1.7 bn. The combination of both led our JPY Sentiment Index score to drop by 22.2 points to 38.8, down from last report's reading of 61. This change in JPY net positioning accounts for potentially all of the increase in overall USD net positioning, up by $4.3 bn on the week, as changes in net positioning in the other seven currencies included in the report broadly canceled each other out.

Part of the fundamental shift is the market's expectation that the BOJ will shortly resume yen "printing" that will overshadow (on a relative basis) what the Fed is doing. And that will cap yen's appreciation even in the face of risk assets selling off.

After reaching its peak of over $1.2 trillion reached in 2007, Asset Backed Commercial Paper (ABCP) outstanding has continued its decline. The rapid growth was originally triggered by the use of commercial paper to fund RMBS, CDO bonds, SIVs, etc. But in early 2007, as subprime defaults picked up, US money market funds stopped buying ABCP, forcing banks who backstopped the commercial paper programs to move CDO bonds, etc. onto their balance sheets (that's the sharp decline in late 2007 on the chart below). This is what ultimately caused Citibank and Wachovia to become insolvent.

Source: St. Louis Fed

The ABCP market has undergone a dramatic change since then. Most of the programs are now so-called bank sponsored multi-seller facilities (multiple issuers use the CP program to fund their assets) - which provides some diversification. And the assets funded are much simpler these days - generally short-term ABS (autos, cards, etc.)

JPMorgan: - Today, the ABCP market comprises mainly of plain
vanilla, traditional multi-seller conduits. Gone are the
days when the market included more-sophisticated
structures such as SIVs (structured investment vehicles) or
securities arbitrage conduits. Although there are some
securities arbitrage programs still outstanding, most are in
the process of winding down as they let their securities run
off. These are securities such as RMBS, CMBS, and
CDOs, which most sponsors/investors would rather not
continue to fund. Indeed, based on data we collected from
our partners in banking, 75% of the ABCP market today
comprises multi-seller conduits sponsored by banks or
independent companies versus 54% five years ago — a reflection of investors’ preference for this type of
structure.

Source: Blackrock

However even the multi-seller programs are shrinking. The sharp declines in ABCP this year have been driven by the Eurozone crisis, as money market funds no longer fund programs set up by French, German and UK banks in the US. No money market fund wants to show European exposure on its regular investor reports - even exposure to stronger EU institutions. Japanese, Canadian, and US banks, particularly Citibank, continue to manage some of the active ABCP programs.

JPMorgan: - It’s not surprising then that the largest ABCP programs
currently are multi-seller conduits sponsored by US,
Canadian, and Japanese banks—credits that investors have
sought after away from the Eurozone. These programs
continue to benefit from better pricing and market access
compared to European administrators. For example, an A-
1/P-1 US ABCP conduit could obtain 1 [month] funding around
15bp (LIBOR - 5bp) versus an A-1/P-1 French ABCP conduit
around 25-35bp (L + 5/15bp). Even Citigroup (A1/P-
2/F1) remains the largest overall and US sponsor of multiseller
conduits. They currently fund below the French
conduits in 1 [month maturity]. With that said, [Citibank's] funding capacity
would likely be severely limited if they suffer any more
ratings erosion such that they become a Tier 2 issuer.

Source: JPMorgan

Banking organizations in the US with strong ratings will continue to run relatively small ABCP programs. They are quite useful to facilitate non-bank consumer lending (a form of "shadow banking"). Often if you buy or lease a car in the US, the loan or lease ultimately becomes part of an ABS and is financed with ABCP. But the ABCP market is now a shadow of its former self and the amount outstanding continues to decline to new lows.

Thursday, October 25, 2012

It is time once again to take a closer look at the latest Eurozone consumer sentiment and business conditions surveys. These measures tend to be leading indicators for the trajectory of corporate earnings and GDP growth. The first one is the Markit PMI.

Markit: - The Eurozone sank further into decline at the start of
the fourth quarter, with the combined output of the
manufacturing and service sectors dropping at the
fastest rate since June 2009.

The Markit Eurozone PMI® Composite Output
Index fell for a third successive month, down from
46.1 in September to 45.8 in October, according to the
preliminary ‘flash’ reading based on around 85% of
usual monthly replies. Output has fallen continually
since September of last year with the exception of a
marginal increase in January.

Output continued to fall in response to a further
marked contraction in new orders. The rate of decline
in new business eased slightly since September,
which had seen the largest drop since June 2009.

It is interesting to see the PMI numbers diverging from the GDP - the so-called "soft data" - "hard data" divergence (chart below). It is possible that the actual business conditions are indeed better than the business survey would suggest - it has happened before. But in most cases the divergence was temporary and by the end of the year we should see which was closer to reality.

Source: Markit (click to enlarge)

These weak business surveys are not just driven by the periphery nations. Germany's IFO Institute indicators are showing an unexpectedly worrying trend as well.

Source: IFO Institute (click to enlarge)

Households surveys in the Eurozone paint a similarly bleak picture. The EC consumer confidence (which ticked up slightly), expectations for the economy, and particularly personal finances are all quite weak. In fact the expectation of "own financial situation in the next 12 months" touched the all-time low reached in 2008. Eurozone households have completely lost confidence in the sustainability of their personal finances going forward.

Source: EC, BNP Paribas (click to enlarge)

With such weakness in business and the consumer sectors across the Eurozone, economists now turn to the German GfK consumer sentiment (2AM EST). The number is expected to be stable (expectation is 5.9) but there are clearly risks to the downside.

FT: - A poor week for the German economy will focus more eyes on the latest data from the eurozone heartland, the GfK consumer sentiment index released on Friday.

While stable numbers are expected from the German consumer, caution is the watchword after the surprise this week of the Ifo business confidence gauge hitting two-and-a-half-year lows and German PMI data declining for a sixth straight month. Could Germany become a bigger worry in the eurozone?

Global risk appetite continues to improve. The CS index is still below the early 2012 LTRO-induced euphoria, but is on the rise nevertheless. The dotted line indicates "panic" level, which is exactly where the index was a year ago (see post from last December).

The divisiveness, gridlock, and political mudslinging in US politics - as bad as it sometimes gets - is by no means a new phenomenon. Furthermore the founders of the US political system may have intended for it to function in exactly such a way. In fact the Obama-Romney fight is child's play in comparison to some political campaigns of the past.

Here is a good colorful passage from a recent essay by George Friedman of Stratfor that puts modern politics in perspective.

George Friedman: - We like to think that our politics have never been less civil than they are today. Given that Andrew Jackson's wife was accused of being a prostitute, Grover Cleveland was said to have illegitimate children and Lyndon Johnson faced the chant "Hey, hey, LBJ, how many kids did you kill today?" I will assert that the Obama-Romney campaign doesn't even register on the vilification scale.

The founders wouldn't have minded this culture of contempt for politicians. In founding the republic, their fundamental fear was that the power of the state would usurp the freedoms of the states and individuals. They purposefully created a political regime so complex that it is, in its normal state, immobilized. They would not have objected if professional politicians were also held in contempt as an additional protection. Ironically, while the founders opposed both political parties and professional politicians, preferring to imagine that learned men take time from their daily lives to make the sacrifice of service, many became full-time politicians and vilified one another. Thomas Jefferson's campaign said of John Adams that he had a "hideous hermaphroditical character, which has neither the force and firmness of a man, nor the gentleness and sensibility of a woman." Adams' campaign stated that Jefferson was "a mean-spirited, low-lived fellow, the son of a half-breed Indian squaw sired by a Virginia mulatto father." And Jefferson and Adams were friends. I would suggest suspending the idea that we have never had so vicious a politics.

The stagnation in lending is in part due to banks deleveraging in order to improve capital ratios for Basel III. But a big part of the issue is simply lack of demand from borrowers.

AP via Yahoo: - The numbers show the economy is struggling despite efforts by the central bank to stimulate credit and calm financial markets fearful that the eurozone might break up. The ECB has cut its main interest rate to a record low 0.75 percent and made €1 trillion ($1.3 trillion) in cheap loans to banks that don't have to be paid back for three years.

Even so, that easy money is not making it from banks to businesses and consumers, largely because demand for credit remains weak.
Businesses see no reason to borrow to invest in expanding production. Meanwhile, banks in some countries have less to lend because they are struggling to recover from losses on real estate loans that didn't get paid back and on government bonds that have fallen in value due to fears about those governments' finances.

Liquidity is trapped in the Eurozone core where businesses are borrowing less, while periphery banks have limited liquidity even if there was demand. Either way, liquidity provided by the ECB is not making it into the private sector, as the growth in money supply diverges materially from growth in lending to the private sector.

Source: GS

Note that this weakness in credit growth in the Eurozone is in stark contrast with the US, where banks continue to lend at a steady pace. This trend started in early 2011 (driven mostly by corporate lending) and seems to be ongoing.

Early in the year Greg Merrill discussed the current administration's decision to shut down the Keystone pipeline project and the issues surrounding that policy. That was obviously not the end of the story. If there is a need, the energy industry will find a way.

In recent years the various natural gas shale projects have changed the configuration of natural gas delivery in the US. That means some of the traditional routes used to transport natural gas to a number of areas - some over long distances - are no longer economical. And now a number of these gas lines could be modified to transport crude, sometimes in the opposite direction.

JPMorgan: - Given the regulatory challenges facing the construction of some new oil pipelines in North America, many
companies are turning to converting existing assets to oil service. With natural gas supplies growing in
numerous regions from shale plays such as the Marcellus, gas pipelines delivering along historical routes
into these regions are becoming underutilized, providing options for conversion to transport crude oil.

At least four gas lines are under discussion for conversion into oil service that could move oil out of
Canada, the US Gulf Coast, and upper Midwest areas. One of the pipes making up TransCanada’s
Mainline gas network that runs from western Canada to the eastern border is under consideration for
conversion to crude oil, which could reportedly deliver 0.5 to 1.0 mb into Padd 1 and eastern Canadian
refineries. Additionally, Energy Transfer Partners has petitioned the US Federal Energy Regulatory
Commission to repurpose the Trunkline natural gas line into crude service and reverse the direction to run
south from the upper US Midwest into the Gulf Coast. The Pony Express line originating in Wyoming
completed an open season for deliveries of approximately 230 kbd of crude into Oklahoma in 3Q2014 after
being in gas service since 1997. Lastly, parts of the underutilized El Paso Natural Gas (EPNG) pipeline
system are being considered for conversion to transport an estimated 400 kbd of crude to southern
California refineries from west Texas.

Here is an example. The Trunkline gas line, developed to deliver natural gas from the Gulf Coast to the Midwest is no longer economical because these customers (in most cases) can get gas from nearby shale sources.

Panhandle Energy: - Trunkline Gas Company operates a 3,059-mile pipeline system with access to Gulf Coast supply sources which can deliver 1.5 Bcf/d of natural gas to Midwest and East Coast markets. Our Midwest customer base includes some of the nation's largest utility and industrial gas users in Chicago, Michigan, Memphis and St. Louis.

The line doesn't follow the proposed Keystone path exactly, but it could get crude to the Gulf Coast nevertheless. And that's the idea - just move oil in the opposite direction. Of course just like Keystone, these projects are also going to face a great deal of opposition.

Petroleum News: - Operating in the shadows, Energy Transfer Partners, ETP, is trying to gain an edge over others — notably TransCanada and the partnership of Enbridge and Enterprise Products Partners, EPP — to offer pipeline access from the Bakken, Alberta oil sands and the Utica shale plays to Gulf Coast refineries.

Industry sources say its plan is pinned on reversing its 770-mile Trunkline system to a southbound operation from the Midcontinent, shifting from the declining natural gas business to the shale-rich core of the United States and beyond to Alberta. They are projecting that the switch to a Gulf-bound crude pipeline could expand Trunkline’s capacity to 400,000 barrels per day from 150,000 bpd.
...
Although ETP has kept tight-lipped about its plans, the proposal was dragged into the public spotlight through a motion to “intervene and protest” by Michigan Gov. Rick Snyder filed with the Federal Energy Regulatory Commission.
Snyder said the proposal to convert a “key piece of the natural gas infrastructure” in Michigan into an oil pipeline “will not serve Michigan’s energy needs” to heat homes and businesses in a large part of the state.

One way or another the industry will find ways to get crude to the Gulf. As it does so, the US job market should benefit - as it did in Canada - with multiple businesses springing up to support these projects.

Wednesday, October 24, 2012

It looks increasingly likely that going forward the dollar LIBOR curve will be set based on term deposit rates (discussed here). There simply is not enough term (longer than one week) interbank unsecured lending to determine LIBOR without the risk of potential manipulation (or perception of manipulation).

A term deposit is commonly referred to as a "CD" (certificate of deposit) and most banks publish these rates daily. In effect it is the rate at which banks can borrow from the public for a period of time. The convergence between LIBOR and CD rates is now clearly taking place.

Source: BankRate.com/Bloomberg

This is good news in terms of transparency because CD rate averages are easily available, leaving little room for manipulation. One can monitor the CD curve over time to see where banks are funding themselves out to 5 years. The chart below shows the CD curve now and a year ago. Rates basically have not changed out to 9 months, but have come in beyond that point. Any funding strains in the banking system will quickly become apparent in this curve.

Source: BankRate.com

CD rates also tell us which banks are having a tougher time raising deposits or issuing bonds. As the table below shows, some of the smaller/newer banks, internet banks, or banking firms that don't have enough bank branches (such as CIT, MetLife, or Sallie Mae) will pay more for term deposit funding.

Here is an interesting interview with Gordon Chang, who believes that China's GDP growth in Q3 has been grossly overstated. In his opinion the number should be closer to zero.

His view is based on slow growth in electricity production across China as well as consistently weak PMI numbers. The HSBC PMI has been showing a mild contraction every month throughout 2012.

China PMI (Source: HSBC/Markit)

He also points to an increasing risk of social unrest in China - which hasn't been covered by the media. This stems directly from the slowdown and the wealth inequalities that have developed in the country in recent years.

YF: - Another area of concern for Chang is the potential for unrest. While the saga surrounding workers at the Foxconn factories where Apple gadgets are made has been well covered, Chang says it barely touches on what is happening on a broader scale.

"Across Chinese society, the one factor that people always talk about is the anger," he says. But the reality is that the central government in Beijing no longer produces statistics on uprisings and protests, which by his estimates are now probably occurring at a rate that is ''north of 200,000 per year."

Tuesday, October 23, 2012

It is a well known fact that homeownership in the US has been on a decline, a trend that started even before the financial crisis. Now Moody's predicts this trend will begin reversing next year.

Dotted curve is Moody's projection (Source: Moody's)

Their explanation has to do with demographics. Baby boomers are moving into the highest homeownership group by age, while "echo boomers" (children of baby boomers) are getting to the age at which they are significantly more likely to own a home than the younger age group.

Moodys: - Demographics will also generate much of the gain in homeownership over the next decade, with a growing share of households aging into the highest homeownership groups. Baby-boomers are aging into the 65 and older cohort, the age group with the highest homeownership rate, while echo boomers have entered the 30- to 45-year-old cohort, which traditionally makes the largest gains in homeownership.

Historical data tends to support this assumption. The jump in ownership from the 25-29 cohort to the 30-34 is the sharpest - which is where echo boomers are now transitioning.